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How Will Interest Rates Impact Your Business Projects?

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Funds are available for your corporate projects, but given rising interest rates, is it the right time to invest?

Did you put your investment projects on hold in the first year of the pandemic? Did you postpone discussions about the sale of your business by a year? Did you have to quickly invest in technologies to adapt to the new reality? Would you like to resume your projects, but the current state of inflation is raising new concerns?

If you’re nodding your head, slightly discouraged, you’re not alone. Each organization is unique and you need to take the time to analyze your situation.

Unprecedented increase in 30 years

Inflation is rampant, with increases we haven’t seen in 30 years of 6.8% over a 12-month period (April 2021 to April 2022), especially in oil prices, which have also risen, mainly due to the armed conflict in the Ukraine.

The global stock market has had a difficult start to the year with its main indexes declining (notably -12% for the S&P 500, -8.5% for the Dow Jones and -23% for the NASDAQ), despite a slight increase since the end of May.

With many government assistance programs ending and a growing shortage of skilled labour, business leaders are being held back in their productivity and growth.

The World Bank is talking increasingly about the risk of global stagflation, and we need to be cautious in our forecasts.

Financing is available

The good news is that there’s still a lot of money in the market currently. While many companies sped up their plans in the second year of the pandemic and have already put their projects into motion, many investment funds still have plenty of cash to lend and institutions are willing to participate in the economic recovery.

As for the banks, they set aside large cash reserves at the beginning of the pandemic to deal with possible client defaults, but these reserves were, in fact, little used. This in itself is excellent news, as it means that our companies have fared better than expected. The reserved funds are now available for businesses.

The prime guideline of different government bodies is to support the economic recovery, which is being done through various programs, or by increased flexibility in credit decisions. In short, funds sources are there for entrepreneurs who wish to move forward.

Interest rates as a risk factor

However, rising interest rates (current and future) are a factor to consider in your calculations and strategy. The Bank of Canada has raised its prime rate by 0.25% (March 2022), 0.5% (April 2022) and 0.5% a second time (June 2022) to 1.5%. There is no danger at the moment, as the Bank of Canada’s pre-pandemic prime rate was 1.75%. So, we are almost back to that level. But it’s not over yet.

Since the economic crisis of 2008-2009, the average posted five-year fixed bank rates (the favourite rate of Canadians) have fluctuated around 5%. Since bank data on this topic was not available before 1970, it’s safe to say that we have not seen such a level in over 50 years.

The Bank of Canada announced quite clearly that increases were coming in the next few months in an attempt to slow down inflation. This will most likely be – opinions vary among the economists of the major banks – from 0.5% to 1.5%. The Bank of Canada recently warned that an increase of 0.75% in July was not excluded. It’s a safe bet that inflation will have to be considerably milder before it stops.

In this context, Canada’s major banks decided to raise their prime rate from 2.45% as of March 2020 to 3.2% in April 2022. By comparison, the only other time this benchmark rate has been lower was in 2009 in the midst of the economic crisis, when it was 2.25%.

Don’t panic, the rates are still what we would generally call “low”. The longer-lived among us will remember the period in the early 1980’s when rates were between 15% and 25%. Let’s just say that the rate of return calculations are not the same for an investment project in this context.

Please understand that we are very far from this level, but it’s still important to plan for your project’s financing so that the variable interest rates do not become an important risk factor.

Which rate structure should you choose for your business?

Unfortunately, the answer to this question will always be: “It depends”, especially:

  • If one of the pledged assets will potentially be sold in the short term;
  • If you have a significant margin in your cash flow from operations to potentially absorb a short-term rate increase;
  • On your level of risk tolerance;
  • On your interest in entering into new negotiations with your financial partner next year.

These factors are the same as in a low interest rate situation, as we have experienced in the last 13 years.

However, you should be aware that costs are rising, which means that the overall cost of your project increases and that your internal rate of return calculation will be affected.

If you’re a buyer, this will lower the price you are willing to pay to conclude the transaction.
On the other hand, if you are a seller, you must be aware that the market rates may have an impact on your business’s valuation and that buyers will have this in mind during their considerations.

Depending on their financial situation, buyers will also potentially see their borrowing capacity reduced and, consequently, the price they are able to offer you. Perhaps they will still want to go ahead and honour the price agreed upon, but will ask you to be more involved (e.g., by a larger balance of sale).

The right decision will always be the one that fits in with your short-, medium- and long-term goals. It’s important to assess your situation and make sure that you don’t jeopardize your operations’ sustainability.

Different choices based on project nature

Remember that you’re an entrepreneur, not a trader on the financial market. Forget about complex structures involving interest rate swaps and the like. If you don’t fully understand the ins and outs of what is being proposed, choose another solution. However, if you have the right guidance to understand this type of structure, there may be some interesting opportunities.

Furthermore, the transaction circumstances may have an impact on the rate you are offered, or choose. For example, the acquisition of a building is currently very easy to finance and you will probably opt for the lowest rate offered to you.

However, perhaps a lack of excess cash flows will lead you to opt for a loan-to-value ratio of 100% or more, which will result in a higher interest rate.

Let’s take another example, the type of project that puts the most stress on an organization’s financial structure: an acquisition. If you’re acquiring a business, it’s probably best to go with a lenient and flexible financing structure, which is likely to have a higher interest rate. If the context is right, the additional cost of the higher interest rate will probably be worth it for the reduced operational risk it provides.

Financing a project: a complex process

Financing a project requires careful consideration and analysis of your needs. To ensure that you make the best decision for your business, an expert’s support can be a valuable asset. He or she will be able to advise you on the best course of action and assist you in the search for financing and negotiating with financial partners.

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